A Brief History of Bank Capital Requirements in the United States Joseph G

Number 2020-05 February 28, 2020

A Brief History of Bank Capital Requirements in the United States Joseph G. Haubrich*

Modern capital requirements can appear to be overly complex, but they reflect centuries of practical experience, compromises between different regulators, and legal and financial systems that developed over time. ThisCommentary provides a historical perspective on current discussions of capital requirements by looking at how the understanding of bank capital and the regulations regarding its use have changed over time.

When Alexander Hamilton and Aaron Burr founded What Is Bank Capital? their rival banks in the 1780s, their charters required At a simple level, a bank’s capital is the stock or equity put them to hold capital, but the rules were far simpler than up by the bank’s owners. The bank then takes in deposits or the hundreds of pages of regulations facing today’s banks. other debt liabilities and uses the debt and equity to acquire assets, which means mainly making loans, but they also buy Today’s rather complicated (some would say arcane) branches, ATMs, and computers. In fact, a rough picture rules may look less arbitrary if viewed as the outcome of of a bank is that it takes in capital and deposits and makes a centuries-long lived experience in a changing financial, loans. So this logic also means the capital, or equity, is the legal, and political landscape. This Commentary provides difference between the value of the assets and the value a historical perspective on current discussions of capital of the liabilities. As such, capital can act as a buffer: If the requirements by looking at how the understanding of loans don’t pay off, the value of the equity gets reduced, bank capital and the regulations regarding its use have but there will (might?) still be enough assets to pay off the changed over time.1 depositors so the bank doesn’t get closed down. And if the loans do well, the capital owners get to keep the profits after paying the interest due to the depositors.

Joseph G. Haubrich is a senior economic and policy advisor at the Federal Reserve Bank of Cleveland. The views authors express in Economic Commentary are theirs and not necessarily those of the Federal Reserve Bank of Cleveland or the Board of Governors of the Federal Reserve System or its staff.

Economic Commentary is published by the Research Department of the Federal Reserve Bank of Cleveland. Economic Commentary is also available on the Cleveland Fed’s website at www.clevelandfed.org/research. To receive an e-mail when a new Economic Commentary is posted, subscribe at www.clevelandfed.org/subscribe-EC.

ISSN 2163-3738 DOI: 10.26509/frbc-ec-202005 This may sound a bit esoteric, but the ideas should be level of capital, which often depended on where the bank familiar to every homeowner.2 To purchase an asset (the was headquartered: Section 7 of the National Banking Act home) the buyer puts up some of his or her own money of 1864, for example, prescribed $50,000 for places with a (the equity) and borrows the rest (the mortgage). If the population of 6,000 or less. State regulations differed both as house appreciates in value, the owner can sell it and make a to capital levels and population, with Maryland at one time profit after paying off the mortgage (the debt). If the house having seven categories and Nebraska eight (Grossman, depreciates, the equity acts as a protective buffer for the 2010, p. 236).3 lender: As long as the house price falls less than the value of Early capital requirements showed more similarity to their the equity, the owner will get enough money from a sale to modern counterparts than readily meets the eye, however. pay back the mortgage. While the law prescribed a minimum level of capital, Because banking is such an important part of the economy, bank charters also restricted bank liabilities to a multiple regulators have established minimum required levels of of capital. Of course, mathematically, requiring 10 percent bank capital, generally requiring more capital if the bank capital is the same as limiting liabilities to being 10 times is larger or is riskier, though exactly what counts as capital capital. This was a restriction on liabilities, not assets (as these days, and how size and risk are measured, becomes capital ratios are phrased today), but the logic of double- quite complex. entry bookkeeping makes a limit on liabilities also a limit on assets. This identity never really held, however, because Early Capital Requirements deposits were often exempted and not counted against the The intricacies of modern capital requirements appear liability limit. It seems that Hamilton and the other bank less tangled when viewed as the outgrowth of centuries founders assumed deposits would be specie, a usage and an of practical experience, of compromises between different assumption that did not last.4 regulators, and of legal and financial systems that developed over time. In Hamilton and Burr’s day, banks were required Exempting deposits effectively made the capital requirement to hold capital, but the rules were far simpler then than a rule that specie backed bank notes and for that reason, today (table 1). In the nation’s earliest years, capital most Hammond (1985) argues that these restrictions actually often meant the specie—gold or silver—originally contributed represented a different type of bank regulation, namely, a by the bank’s organizers to get it started. (Hammond, 1985, reserve requirement. Where a capital requirement specifies p. 134) Unlike today’s capital requirements, which are set the amount of capital that a bank must hold, a reserve in terms of a specified fraction of assets (perhaps adjusted requirement specifies the amount of liquid assets that the for risk), back then the law required a minimum absolute bank must hold. This makes the early capital requirement

Table 1. Summary of Capital Regulations

Time period Capital regulation 18th and early 19th century Banks chartered by states. Banks required to have a minimum level of capital to start. Rules vary by state. National Banking Era, 1864 National banks created; starting capital depends on location of bank. Deposits become more important. 20th century Comptroller considers capital-to-deposit ratio, following states. New Deal lists capital adequacy as requirement for Federal Deposit Insurance Corporation (FDIC) coverage. Post–World War II In 1950s, capital only one component of supervision; risk of assets considered. International Lending Supervision Act of 1983 (ILSA) requires supervisors to create capital requirements. United States implements Basel I in 1989; explicit risk-weighted assets. Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) creates prompt corrective action. 21st century: Basel and Basel II, 2007, creates standardized and advanced approaches. Dodd–Frank Act Basel II and Dodd–Frank Act create capital conservation buffer (CCB), countercyclical capital buffer (CCyB), supplemental leverage ratio (SLR), and global systemically important bank (GSIB) surcharges. Stress tests: Dodd–Frank Act Stress Tests (DFAST) and Comprehensive Capital Analysis and Review (CCAR).

2 that banks hold a certain amount of gold relative to an asset ratio of better than one-tenth capital to total their liabilities look a lot like a reserve requirement. The assets—New Deal legislation had listed adequate capital restrictions soon explicitly required that banks hold a as a prime criterion for deposit insurance eligibility. In fraction of liabilities as specie, which made it a classic 1942, quantitative criteria were effectively suspended to reserve requirement. Gradually, deposits became more aid in the war effort by bank supervisors not wishing to important than bank notes, which eventually disappeared, restrain banks’ purchase of Treasury securities (Orgler leading to today’s reserve requirements, where banks must and Wolkowitz, 1976). The question returned after the hold a certain amount of cash or reserves with the Federal war, however, with the comptroller’s office looking at the Reserve as a fraction of their deposits. ratio of capital to what it termed risk assets, that is, assets excluding cash and government bonds, a very early form The early capital requirements also took the idea of of “risk-weighted assets” that became important later on. capital as a buffer stock very seriously, as equity at times By 1952 the Federal Reserve Bank of New York created had double, triple, or even unlimited liability (Grossman, an explicit formula for weighting different assets by their 2010, p. 237). That meant that if the bank suffered losses, risk, and in 1956 the Board of Governors adopted a similar the equity holders would have to pony up more money. ABC (Analyzing Bank Capital) model. The trend was not Furthermore, capital did not have to be “fully subscribed” monotonic, however, as in 1962 the comptroller, on the before a bank opened: Section 14 of the National Bank Act urging of banks, de-emphasized formulas (Hahn, 1966) of 1863 required just half the capital to be paid in before and even in the 1970s maintained that capital ratios were operations could commence. This created the distinction only one part of a suite of tools for assessing bank health between authorized and paid-up capital. The remaining (Tarullo, 2008). Furthermore, the different regulators had “uncalled’” capital served as an additional buffer in case different definitions of what counted as capital. Capital of losses. An individual might subscribe for, say, $1,000 ratios were used as a supervisory instrument, but the legal of capital, pay in $500 with specie, and remain liable for authority to enforce capital limits was at best unclear. The the additional $500 if the bank had need of it. If the stock Federal Reserve lost a court battle in 1959 when it tried to had double liability, the individual might then be asked to revoke Federal Reserve membership on the basis of capital contribute another $1,000.5 problems (Orgler and Wolkowitz, 1976). Even today, though, double liability is not completely gone, In the 1970s, oil shocks and stagflation created an uncertain at least for firms that own a bank, if not for individual macroeconomic environment. Large firms reduced their investors. An echo remains in the Federal Reserve’s “source dependence on banks by accessing commercial paper and of strength” doctrine, whereby companies that own or other products in the capital markets; savers moved into control a bank may be liable for more than their original money market funds. Several high-profile failures, such as capital investment. The roots trace back to aspects of the Herstatt and Franklin National, highlighted the problem. 1956 Bank Holding Company Act, but the doctrine was Banks’ efforts to compete led to the erosion of the New Deal refined and explicitly added to the Federal Reserve’s Reg Y regulatory regime, which was based on restricting activities in 1984. It became legislatively codified in section 616(d) of and investments. As the old regime crumbled, supervisors the Dodd-Frank Act (Lee, 2012a, 2012b). increasingly moved to capital regulation as a substitute for The Twentieth Century direct control. In 1981 the Office of the Comptroller of the In the early years of the twentieth century, the focus began Currency (OCC) and the Federal Reserve jointly issued to change from a minimum absolute level of capital toward formal capital ratios, of 5 percent capital to assets, while the the more modern idea of requiring capital based on the size Federal Deposit Insurance Corporation (FDIC) separately and risk of the bank. In 1914, Comptroller of the Currency issued a 5 percent guideline (Tarullo, 2008). In 1983 this was John Skelton Williams proposed legislatively mandating a extended to the largest 17 banks in the United States, and capital-to-deposit ratio of one-tenth (Hahn, 1966), though later that year legislation explicitly required the agencies to the proposal never became law. The notion of capital set capital ratios. The legislation (the International Lending limiting liabilities, such as deposits, rather than assets, such Supervision Act of 1983, or ILSA) was in part a response to as loans and investments, still held sway. This view even a court ruling that regulators did not have authority to close has some modern adherents: The Nobel Prize winner a bank based on a low capital ratio by itself. Roger Myerson has suggested that capital requirements be Basel Takes Center Stage phrased in terms of ratios to liabilities, as the point of capital Throughout the 1970s and early 1980s, while capital was is to provide a buffer that makes the bank’s liabilities safer becoming a more important regulatory tool, international (Myerson, 2014). aspects of capital regulation became increasingly prominent. Critics of the capital-to-deposit ratio argued that a bank Worries that differing regulations created an uneven playing suffers losses when its assets underperform, so an asset field, giving some large international banks (particularly the ratio better measures the ability to absorb losses. In Japanese) an unfair advantage, coupled with concerns about 1939 the FDIC defined capital adequacy as having bank resilience after the Latin American debt crisis, led to

3 a renewed emphasis on coordinated requirements across a somewhat arbitrary number of risk classes and weights. countries (Wagster, 1996). The forum for this was the And while some of the issues could be addressed, such as Basel Committee on Banking Supervision (BCBS), a group by the amendment of 1996, which added market risk (the created by the G-10 countries and housed at the Bank for risk of interest rate changes for those assets the bank held International Settlements (BIS) in Basel, Switzerland. for trading) to the accord, other developments, such as the rise of securitization and the development of internal This is not the place to go into the rather complicated risk models by banks, required more extensive changes. international politics that led to the first Basel agreement, For example, in the securitization process, a bank could known as Basel I, but the final version of the accord sometimes reduce its capital requirement without reducing was released in July 1988. However, as an international its risk by selling off a portion of its loans and buying back agreement it had to be implemented by the separate only the risky part (or “tranche”) of the resulting security. national authorities, which for the United States occurred in While securitization and other off-balance-sheet activities January 1989 (with a four-year transition period). provided many advantages to banks and borrowers, such as The major reform of the Basel I accord was the introduction diversifying balance sheets, they also were prone to being of risk-weighted assets (RWA). The worry was that a used for such regulatory arbitrage. straight capital ratio did not depend on an asset’s risk, and To address these weaknesses, the international community so made no distinction between a bank with loans to major again worked through the BCBS for a second accord. Basel corporations and AAA rated bonds, and one loaded up II did not change the minimum capital level, but it made on risky ventures. A capital requirement might then even major changes to the way RWA was calculated. Smaller encourage banks to take more risk, getting a higher return banks could continue to adhere to the Basel I rules for for the same amount of capital. Basel’s approach was to calculating RWA, dubbed the “standardized approach,” assign assets to one of five categories of credit risk, with but larger banks also had to apply a new formula, dubbed the riskier categories requiring more capital. For example, the “advanced approach.” This involved calculating a sovereign debt was given a weight of 0 percent, residential (rather complicated) formula based on expected losses mortgages got 50 percent, and commercial loans 100 produced by a bank’s own internal risk model. Affected percent. In addition, there were conversion factors for off- banks are required to have capital equal to the greater of the balance-sheet items, such as loan commitments, which had standardized and advanced approaches. not previously been subject to capital requirements at all. Basel I created two minimum capital requirements, one for Basel Meets Dodd and Frank core capital, termed “tier 1” at 4 percent of RWA, and one The US rules implementing Basel II were finalized in July for total capital, which was the sum of tier 1 capital plus 2007, to take effect in April 2008. This timing guaranteed a additional items called “tier 2” capital.6 These definitions need for a Basel III to respond to the great financial crisis. were somewhat different from the US definitions of As in the case of prompt corrective action, national and “primary” capital and “total” capital used before Basel international changes moved in parallel. Basel III standards (Walter, 2019, p. 11). However, US supervisors retained a were promulgated by the BCBS in December 2010, shortly capital ratio against total assets (that is, not risk weighted), after the July signing of the Dodd-Frank Act (DFA). In 2013, termed a leverage ratio. This was meant to protect against US regulations effectively jointly implemented both strands risks beyond credit risk, and sprang out of a fear that some of capital requirements. banks might become highly leveraged by concentrating on Basel II promoted 3 pillars of capital regulation: minimum assets with lower risk weightings. capital requirements, supervisory review of capital National regulators did not always wait for international adequacy, and market discipline. Pillar I on minimum consensus: A major change in US capital requirements capital requirements proved most amenable to detailed arrived in 1991 with the Federal Deposit Insurance regulations, and along with adjusting the requirements for Corporation Improvement Act (FDICIA), which introduced credit risk and securitization exposures, brought in market prompt corrective action (PCA). The idea was to get banks risk and operational risk to the picture. to build up their capital before it became so low that they The new regulations applied to all banks and to bank failed or were closed. FDICIA created categories of capital holding companies (companies that owned or controlled ratios based on total, as opposed to risk-weighted, assets. a bank) with assets over $1 billion. The regulations also Banks below the highest category, “well capitalized,” were introduced a new definition of capital, “common equity subject to restrictions on executive pay and on acquiring tier 1” (CET1), in response to concerns that tier 1 capital other banks or branches and could face heightened was too broad a definition and did not provide a sufficient supervision. If a bank was critically undercapitalized, buffer during the crisis. A minimum CET1 ratio was the regulator had to put the bank into receivership or added to the previous requirements—the tier 1, total, and conservatorship. leverage requirements remained. The definitions behind risk Even as it was rolled out, people were aware of weaknesses weighting also were shifted, with many more risk categories in Basel I, such as considering only credit risk, and choosing than the five (four in the United States) initially specified in 4 Basel I. Some of these risk weights exceeded 100 percent so and thus getting shut down but now faces the prospect that an item contributed more to RWA than its value. of being shut down for violating capital requirements. The supervisory stress test attempts to get around this The regulation implementing Basel III and the DFA problem by making sure banks will have enough capital to considerably complicated bank capital requirements, operate when conditions get bad—when there is a “stress and to a great degree this was deliberate, with the idea environment.” Banks (and bank holding companies) are that large and more sophisticated banks should face required to project revenues, losses, reserves, and capital stiffer requirements. In part, these stricter standards were under three stress scenarios, denoted the baseline, the implemented by creating requirements for a series of so- adverse, and the severely adverse scenarios. Banks are called capital buffers. There is the capital conservation required to show that they will have enough capital to meet buffer (CCB), which requires banks to retain earnings if requirements under the stress scenarios. The stress tests their capital is less than 2.5 percent above the minimum actually come in two flavors: those mandated by Dodd- ratio, with the restrictions getting stricter the further Frank, known as Dodd Frank Act Stress Tests, or DFAST, the buffer falls below 2.5 percent. Large bank holding and for larger firms, the Comprehensive Capital Analysis companies that are felt to be particularly important and and Review, or CCAR. designated a global systemically important bank (GSIB) also face the GSIB surcharge, an additional charge The stress tests represent a large departure from previous calculated to offset the systemic risk caused by being a capital requirements. While the forward-looking estimate GSIB. On top of that, the GSIBs have to meet a total loss of losses builds on the advanced approach requirements of absorbing capacity (TLAC) threshold, where they must Basel II, where banks had to hold capital against expected meet a minimum ratio of equity plus long-term debt. The losses, the stress tests add scenarios meant to mimic the idea is to provide an additional buffer (loss absorbing losses observed in a recession or other adverse stress event. capacity) before depositors and the FDIC take a loss. Furthermore, tests results for individual firms are publicly disclosed. This allows regulators and particularly the The supplemental leverage ratio (SLR) is not a buffer on public to make horizontal comparisons across firms with top of other requirements, but for those banks using the regard to their capital positioning. The repeated nature of advanced approach, it has them calculate leverage in an the test (occasionally for DFAST, yearly for CCAR) also alternative manner, including off-balance-sheet items encourages firms to improve their risk measurement and such as derivatives and credit commitments. These risk management techniques, perhaps as important a result advanced-approach firms must meet both the 4 percent as requiring enough capital. leverage ratio and the 3 percent SLR. GSIBs have a 2 percent “leverage buffer” added to their SLR and thus Conclusion face a 5 percent standard. Since the time of Hamilton and Burr, the laws and Along with tailoring capital requirements to differing banks, regulations around bank capital have changed dramatically, the regulation implementing Basel III and the DFA also both in format and scope as the economic, financial, and tailors the requirements to economic conditions. The capital legal environment has changed. And the evolution has not rules described so far apply whether the economy is in a ended. In May 2018 the Economic Growth, Regulatory boom or in a recession and cannot easily be varied when Relief, and Consumer Protection Act (EGRRCPA) risks in the financial system change. The countercyclical amended provisions in the Dodd-Frank Act, adjusting risk capital buffer (CCyB) is an attempt to add some cyclical weights and changing the capital planning requirement variability to the regulations: It can vary between 0 percent associated with the stress tests. In 2019, the Federal Reserve and 2.5 percent of RWA and is set at the discretion of the proposed consolidating the capital buffer with the stress test national authority, which, in the case of the United States, requirements, tailoring the buffer to the risk of individual is the Board of Governors of the Federal Reserve. Like banks (Quarles, 2019). So it is quite likely that the long the CCB, the CCyB is meant to get banks to build up the evolution of capital requirements will continue. buffer, and so they face restrictions on earnings disposition until they reach the level. Footnotes 1. This Commentary is not meant to provide legal advice or Stressing the Last Taxi supervisory guidance on current capital requirements. One conundrum created by capital requirements is often 2. Admati and Hellwig (2013) use this analogy to great referred to as the last taxi problem. It stems from an old effect. story about a traveler arriving by train late one evening. Worried about being able to find a cab so late in the 3. What is often considered a major determinant of a firm’s evening, he is relieved to see a taxi waiting, under a sign capital structure (Myers, 2001), the corporate tax rate, saying “one taxi must always remain at the train station.” did not play a major role in the early American economy. The traveler hops in the cab, names his hotel, but the cabbie The corporate income tax was introduced on a permanent refuses to move, and points to the sign. Thus a bank has footing in 1909, with a temporary measure having been capital to protect against losses and against going insolvent used in the Civil War (Slemrod, 2008). 5 4. It also seems that regulators then were less concerned Lee, Paul L. 2012a. “The Source of Strength Doctrine: with protecting depositors than with protecting people Revered and Revisited—Part I.” The Banking Law Journal, holding the other large class of bank debt, namely, bank 129(9): 771–801. notes. Remember that throughout the 1800s the “money” Lee, Paul L. 2012b. “The Source of Strength Doctrine: in circulation was more likely to be a note issued by a bank Revered and Revisited—Part II.” The Banking Law Journal, rather than government currency. Protecting note holders 129(10): 867–906. was considered more important, as they were often poor, and failure of the bank to pay would be a particular burden Myers, Stewart C. 2001. “Capital Structure.” Journal of on them (Smith, p. 343, 1976). Economic Perspectives, 15(2): 81–102. https://doi.org/10.1257/ jep.15.2.81. 5. Double (or higher) liability became less common after the 1930s, with Arizona (the last remaining state with it) finally Myerson, Roger B. 2014. “Rethinking the Principles of removing it in 1956 (Esty, 1998). Bank Regulation: A Review of Admati and Hellwig’s ‘The Bankers’ New Clothes’.” Journal of Economic Literature, 52(1), 6. Tier 1 capital includes common stockholders’ equity, pp. 197–210. https://doi.org/10.1257/jel.52.1.197. noncumulative perpetual preferred stock, minority interest in consolidated subsidiaries, and some other items. Total Orgler, Yair E., and Benjamin Wolkowitz. 1976. Bank capital adds in tier 2 capital, which includes some amount Capital. Van Nostrand Reinhold, Cincinnati. of allowances for loan losses, cumulative perpetual preferred Quarles, Randal K. 2019. “Refining the Stress Capital stock, long-term preferred stock, and some subordinated Buffer.” Speech by the vice chair at Program on debt. In addition, tier 2 capital cannot exceed tier 1 capital. International Financial Systems Conference, Frankfurt, References Germany (September 5). Admati, Anat, and Martin Hellwig. 2013. The Bankers’ New Slemrod, Joel. 2008. Taxing Ourselves: A Citizen’s Guide to the Clothes: What’s Wrong with Banking and What to Do about It. Debate over Taxes. MIT Press, Cambridge. Princeton University Press, Princeton, NJ. Smith, Adam. 1976 (1776). An Inquiry into the Nature and Esty, Benjamin C. 1998. “The Impact of Contingent Causes of the Wealth of Nations, Edwin Cannan, editor, Liability on Commercial Bank Risk Taking.” Journal University of Chicago Press, Chicago. of Financial Economics, 47(2), pp. 189–218. https://doi. Tarullo, Daniel K. 2008. Banking on Basel: The Future of org/10.1016/s0304-405x(97)00043-3. International Financial Regulation. Peterson Institute for Grossman, Richard S. 2010. Unsettled Account: The Evolution International Economics, Washington, DC. of Banking in the Industrialized World since 1800. Princeton Wagster, John D. 1996. “Impact of the 1988 Basle Accord University Press. on International Banks.” The Journal of Finance, 51(4): Hahn, Philip J. 1966. The Capital Adequacy of Commercial Banks. 1321–1346. https://doi.org/10.2307/2329396. The American Press, New York. Walter, John. 2019. “US Bank Capital Regulation: History Hammond, Bray. 1985 (1957). Banks and Politics in America: and Changes since the Financial Crisis.” Federal Reserve From the Revolution to the Civil War. Princeton University Press. Bank of Richmond, Economic Quarterly, 105(1): 1–40.